Home Fundamental Analysis Explained Financial Statement Manipulation An Ever-Present P

1/10/2012 2:03:41 AM

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Financial statement manipulation is an ongoing problem in corporate America. Although the Securities and Exchange Commission (SEC) has taken many steps to mitigate this type of corporate malfeasance, the structure of management incentives, the enormous latitude afforded by the Generally Accepted Accounting Principles (GAAP) and the ever-present conflict of interest between the independent auditor and the corporate client continues to provide the perfect environment for such activity. Due to these factors, investors who purchase individual stocks or bonds must be aware of the issues, warning signs and the tools that are at their disposal in order to mitigate the adverse implications of these problems.

Factors That Contribute to Financial Statement Manipulation

There are three primary reasons why management manipulates financial statements. First, in many cases the compensation of corporate executives is directly tied to the financial performance of the company. As a result, management has a direct incentive to paint a rosy picture of the company’s financial condition in order to meet established performance expectations and bolster their personal compensation.

Second, it is relatively easy to manipulate corporate financial statements because the Financial Accounting Standards Board (FASB), which sets the GAAP standards, provides a significant amount of latitude in the accounting provisions that are available to be used by corporate management. For better or worse, these GAAP standards afford a significant amount of flexibility, making it very easy for corporate management to paint a favorable picture of the financial condition of the company.

Third, it is unlikely that financial manipulation will be detected by investors due to the relationship between the independent auditor and the corporate client. In the U.S. the Big Four accounting firms and a host of smaller regional accounting firms dominate the corporate auditing environment. While these entities are touted as independent auditors, the firms have a direct conflict of interest because they are compensated by the very companies that they audit. As a result, the auditors could be tempted to bend the accounting rules to portray the financial condition of the company in a manner that will keep their client happy. Moreover, auditors typically receive a significant amount of money from the companies that they audit. Therefore, there is implicit pressure to certify the financial statements of the company in order to retain their business. (To learn more, see our CFA Level 1 Study Guide: Financial Statements .)

How Financial Statements Are Manipulated

There are two general approaches to manipulating financial statements. The first approach is to inflate current period earnings on the income statement by artificially inflating revenue and gains, or by deflating current period expenses. This approach makes the financial condition of the company look better than it actually is in order to meet established expectations.

The second approach to financial statement manipulation requires the exact opposite tactic, which is to deflate current period earnings on the income statement by deflating revenue or by inflating current period expenses. The reason behind this approach may not be as obvious as in the previous example because it may seem counterintuitive to make the financial condition of a company look worse than it actually is. However, there are many reasons to engage in such activity, such as making a company look bad in order to dissuade potential acquirers, pulling all of the bad financial information surrounding the company into one period so that the company will look stronger going forward, pulling all of the bad financial information into the current period when the poor performance can be attributed to the current macroeconomic environment or to postpone good financial information to a future period when it is more likely to be recognized. (Read more in A Case Study: Earnings Manipulation And The Role Of The Media .)

According to Dr. Howard Schilit, in his famous book Financial Shenanigans (2002), there are seven primary ways in which corporate management manipulates the financial statements of a company. Let’s look at these seven general categories of financial statement manipulation and the typical accounting processes that facilitate the manipulation.

Recording Revenue Prematurely or of Questionable Quality

Recording revenue prior to completing all services Recording revenue prior to product shipment Recording revenue for products that are not required to be purchased

Recording Fictitious Revenue

Recording revenue for sales that did not take place Recording investment income as revenue Recording proceeds received through a loan as revenue

Increasing Income with One-Time Gains

Increasing profits by selling assets and recording the proceeds as revenue Increasing profits by classifying investment income or gains as revenue

Shifting Current Expenses to an Earlier or Later Period

Amortizing costs too slowly Changing accounting standards to foster manipulation Capitalizing normal operating costs in order to reduce expenses by moving them from the income statement to the balance sheet Failing to write down or write off impaired assets

Failing to Record or Improperly Reducing Liabilities

Failing to record expenses and liabilities when future services remain Changing accounting assumptions to foster manipulation

Shifting Current Revenue to a Later Period

Creating a rainy day reserve as a revenue source to bolster future performance Holding back revenue

Shifting Future Expenses to the Current Period as a Special Charge

Accelerating expenses into the current period Changing accounting standards to foster manipulation, particularly through provisions for depreciation, amortization and depletion

Investors should understand that there are a host of techniques that are at management’s disposal. However, what investors also need to understand is that while most of these techniques pertain to the manipulation of the income statement, there are also many techniques available to manipulate the balance sheet, as well as the statement of cash flows. Moreover, even the semantics of the management discussion and analysis section of the financials can be manipulated by softening the action language used by corporate executives from will to might, probably to possibly, and therefore to maybe. Taken collectively, investors should understand these issues and nuances and remain on guard when assessing a company’s financial condition.

Financial Manipulation via Corporate Merger or Acquisition

Another form of financial manipulation can be found during the merger or acquisition process. A classic approach to this type of manipulation occurs when management tries to persuade all parties involved in the decision-making process to support a merger or acquisition based primarily on the improvement in the estimated earnings per share of the combined companies. Let’s look at the table below in order to understand how this type of manipulation takes place.

Proposed Corporate Acquisition Acquiring Company Target Company Combined Financials Common Stock Price

$100.00

$40.00

-Shares Outstanding

100,000

50,000

120,000Book Value of Equity

$10,000,000

$2,000,000

$12,000,000Company Earnings

$500,000

$200,000

$700,000Earnings Per Share$5.00$4.00$5.83

Based on the data in the table above, the proposed acquisition of the target company appears to make good financial sense because the earnings per share of the acquiring company will be materially increased from $5 per share to $5.83 per share. However, the earnings per share of the acquiring company will increase by a material amount for only two reasons, and neither reason has any long-term implications.

Following the acquisition, the acquiring company will experience an increase of $200,000 in company earnings due to the addition of the income from the target company. Moreover, given the high market value of the acquiring company’s common stock, and the low book value of the target company, the acquiring company will only have to issue an additional 20,000 shares in order to make the $2 million acquisition. Taken collectively, the significant increase in company earnings and the modest increase of 20,000 common shares outstanding will lead to a more attractive earning per share amount. Unfortunately, a financial decision based primarily on this type of analysis is inappropriate and misleading, because the future financial impact of such an acquisition may be positive, immaterial or even negative. (For more, seeMergers And Acquisitions: Valuation Matters .)

How to Guard Against Financial Statement Manipulation

There are a host of factors that may affect the quality and accuracy of the data at an investor’s disposal. As a result, investors must have a working knowledge of financial statement analysis, including a strong command of the use of internal liquidity solvency analysis ratios. external liquidity marketability analysis ratios, growth and corporate profitability ratios, financial risk ratios and business risk ratios. Investors should also have a strong understanding of how to use market multiple analysis, including the use of price/earnings ratios, price/book value ratios. price/sales ratios and price/cash flow ratios in order to gauge the reasonableness of the financial data.

Finally, investors should keep in mind that the independent auditors responsible for providing the audited financial data may very well have a material conflict of interest that is distorting the true financial picture of the company and that the information provided to them by corporate management may be disingenuous, and therefore should be taken with a grain of salt. (To learn more, see our Financial Ratio Tutorial .)

The Bottom Line

The known prevalence and magnitude of the material issues associated with the compilation of corporate financial statements should remind investors to use extreme caution in their use and interpretation. There are many cases of financial manipulation that date back over the centuries, and recent examples such as Enron, Worldcom, Tyco International, Adelphia, Global Crossing, Cendant, Freddie Mac and AIG should remind investors of the potential land mines that they may encounter. Investors should also remember the corporate malfeasance recently conducted by the now defunct auditing firm Arthur Anderson. as well as the disingenuous information provided to the general public by the corporate executives of 360 Networks, Lehman Brothers and General Motors leading up to their bankruptcies. Extreme caution should be used while conducting financial statement analysis. (For more, see Biggest Stock Scams .)

Finally, given the prevalence and magnitude of the material issues surrounding financial statement manipulation in corporate America, a strong case can be made that most investors should stick to investing in low-cost, diversified, actively-managed mutual funds in order to mitigate the likelihood of investing in companies that suffer from such corporate financial malfeasance. Simply put, financial statement analysis should be left to investment management teams that have the knowledge, background and experience to thoroughly analyze a company’s financial picture before making an investment decision. Unfortunately, very few investors have the necessary time, skills and resources to engage in such activity, and therefore the purchase of individual securities by most investors is probably not a wise decision. (To learn more, read Common Clues Of Financial Statement Manipulation .)